EMI Reaches Into New Bag of Tricks in Figuring Profit

EMI Group stunned analysts recently when the struggling music giant unexpectedly announced a 31% surge in operating profit for its latest six-month period.

The news, which sent EMI stock soaring, followed a protracted sales slump in which EMI sank to last place in U.S. music sales among the world’s five recording giants. Excluding income derived from a slightly favorable swing in currency exchange rates, EMI’s own shareholder data indicate that earnings from music sales fell 4% during the period--the first six months of fiscal 2000, ended in September.

So how did the British conglomerate post such fabulous gains?

EMI realized a quick $40 million in operating profit by selling part of its equity stake in Musicmaker.com during the online company’s first trading day last July on Nasdaq. In a matter of minutes, the transaction generated four times what EMI earned selling CDs and tapes in the U.S. during the first half of its fiscal year.

In a business built on smoke and mirrors, EMI appears to have come up with a new accounting trick to camouflage weak results by cashing in on the Internet initial public offering boom. Though the strategy is raising questions on Wall Street, rivals are looking to follow EMI’s lead, eager to find new revenue as profit comes under pressure.

The trend underscores music executives’ fascination with manipulating the stock market rather than cultivating the talent market. Faced with exploding costs and shrinking margins, companies have abandoned long-term artist development in favor of short-term yields from one-hit wonders such as the Spice Girls, Hansen and Backstreet Boys.

“We’re at the very beginning of a brave new world that is provoking opportunities for everybody,” said Tony Bates, EMI Group chief financial officer in a phone interview from the corporation’s London headquarters. “All we’re doing is capitalizing on the current flavor of the month. Do we anticipate generating more money from this type of income stream in the future? Yes, we do. It’s there. It’s real. It’s going to become part of the normal course of our business going forward.”

EMI claims to have nearly two dozen similar investments in the pipeline that could potentially deliver a steady new stream of operating profit. And it may not be long before EMI’s competitors jump on the bandwagon.

Executives at Seagram are privately kicking around the idea of spinning off its recently launched Internet record label Farmclub.com. BMG is considering backing Arista Records founder Clive Davis in a major label start-up with online potential that would eventually go public. And Sony Music is mulling similar online arrangements.

But not everyone is enthusiastic. Although EMI shares have jumped 28% since the Musicmaker stock sale, some analysts question the company’s accounting practices. They say the transaction has nothing to do with EMI’s core business and should not be logged as operating profit--a classification traditionally reserved for income generated by the sale of musical recordings or song publishing.

In a statement to shareholders, EMI referred to the gain as “licensing income,” explaining that it had acquired an equity stake in Musicmaker.com through a licensing deal that gave the online firm access to EMI’s song catalog. In fact, EMI realized its windfall not by licensing songs but by flipping shares--a feat that would be extremely difficult to repeat on a reporting cycle basis.

Some analysts believe it would be more accurate for EMI to book the money as a nonrecurring gain. “If you’re a record company looking for a quick fix, EMI has come up with a very clever strategy. But you have to question the long-term viability of this kind of deal,” said Michael Nathanson, an entertainment analyst for Sanford, Bernstein & Co. “You can’t confuse or mingle these very serendipitous short-term gains with normal operating profit. EMI may seem smart to be selling shovels when people on Wall Street are digging for gold, but they’re creating a big hurdle for themselves in the long run.”

When EMI struck its deal with Musicmaker.com last summer, the British music giant was in a serious downward spiral in the U.S., the world’s largest music market. The company’s Capitol, Virgin and Priority labels had virtually no hits on the nation’s pop chart and nothing promising in the pipeline. EMI ranked last in U.S. music sales, accounting for a feeble 8% of the market.

Overseas, however, things were picking up. After years of profit warnings and losses, EMI finally scored two hits in Japan last spring and began to deliver stronger results in England and Latin America. Still, EMI sought to prepare Wall Street for flat year-on-year first-half operating profit.

Under the deal, Musicmaker.com. gave EMI a 50% equity stake in the online start-up just two weeks before its July public offering. In exchange, the tiny Reston, Va., company, which offers customized compilation CDs via the Internet, was granted access to a large portion of EMI’s recorded music catalog.

On Musicmaker.com’s first day of trading, EMI sold 3 million shares, 10% of its stake, at $14 per share for a net profit of $40 million. Musicmaker.com shares appreciated 71% to close that day at $24 a share.

But the value of Musicmaker.com, which generated only about $300,000 in 1999 revenue, has dropped significantly. On Thursday, Musicmaker.com shares slipped 13 cents to close at $6 on Nasdaq, and EMI’s American depositary shares rose 75 cents to close at $23.50 in over-the-counter trading.

EMI’s remaining stake in Musicmaker.com is worth about $70 million, which CFO Bates said he could sell in chunks over the next four years. EMI is also counting on racking up additional profit by flipping shares in other speculative Web initiatives soon to be announced.

But all those plans hinge on the concept that the Internet IPO craze will have very long legs. What happens if the new-media market suddenly collapses?

“Do we think the new-media market is going to last forever?” Bates said. “I’m sure at some point it will hit stability, but I think that is some way off.”